Wednesday, December 3, 2008

The Complexities of Carbon Trading

Wouldn't it be great if we had just a single acronym and definition for a tradable carbon offset! But alas that would make the world too simple.

Let's take a look at what we have today in the carbon trading market...


The cap-and-trade approach being used in the European Union (EU) Emissions Trading Scheme (ETS) is based upon the Kyoto Protocol and identifies a number of tradable carbon offsets. The underlying commodity being traded are European Union Allowances (EUA) which have been issued to approximately 12,000 energy-intensive installations with a cap on their emissions as covered by the EU ETS Directive. Each EUA grants a party the right to emit one metric ton of CO2. There also are Certified Emission Reduction (CER) units as another underlying tradable commodity. CERs are carbon credits arising from Clean Development Mechanism (CDM) projects. The CDM under the Kyoto Protocol allows parties from industrialized countries (referred to as Annex 1 countries) with a GHG reduction committment to invest in projects that reduce GHG emissions in developing countries as an alternative to more expensive emission reduction in their own countries. One CER is awarded for a reduction in GHG emissions equivalent in impact to one metric ton of CO2. To complicate matters, there are primary and secondary CERs. With primary CERs, the buyer is exposed to project risk. Secondary CERs isolate the buyer from project risk.

The trading market is directed at both EUAs and CERs, but also includes both futures and options contracts. The futures contract gives the holder the right and obligation to buy or sell the underlying instrument at a certain date in the future, at a pre-set price. In the case of an EUA Futures Contract, the underlying unit of trading is the EUA, with one EUA Futures Contract ("lot") representing 1,000 EUAs. In the case of a CER Futures Contract, the underlying unit of trading is the CER. The options contract gives the holder (buyer) the right, but not the obligation, to exercise the option on or before a future date. The other party (seller) has the obligation to honor the specified feature of the contract. The amount the buyer pays the seller for the option is the option premium. The owner of an options contract can exercise (buy or sell) on or prior to the pre-determined settlement/expiration date. Both parties of a futures contract must exercise the contract (buy or sell) on the settlement date. The underlying commodity for options contracts can be either EUAs or CERs.

United States

The underlying commody traded in the U.S., i.e., on the Chicago Climate Exchange(CCX), is the carbon financial instrument (CFI) contract, each of which represents 100 metric tons of CO2 equivalent. CFI contracts are comprised of Exchange Allowances (analogous to EUAs) and Exchange Offsets (analogous to CERs). Exchange Allowances are issued to emitting Members in accordance with their emission baseline and the CCX Emission Reduction Schedule. Emitting Members have made a voluntary, but legally binding committment to meet annual GHG emission reduction targets. Those who reduce below the targets have surplus allowances to sell or bank; those who emit above the targets comply by purchasing CFI contracts. There are also Exchange Offsets generated by qualifying offset projects. Futures and options contracts are also traded. In addition, the Exchange trades Regional Greenhouse Gas Initiative (RGGI) futures contracts. RGGI is made up of ten northeastern states participating under a cap-and-trade scheme that includes auctioning off permits for CO2 emissions

Further complicating the matter is the fact that in the U.S. there is also trading of Renewable Energy Certificates (RECs). RECs represent one megawatt-hour of electricity generated from a renewable source. They are used to comply with state-mandated requirements associated with the amount of a state's total electricity generation that must by a certain date in the future come from renewable energy. Currently, 28 states have such requirements. RECs are related to GHG reduction efforts because they constitute an alternative to fossil-fueled generation. However, there has been confusion between the REC trading and carbon trading markets, although the REC trading market has been designed for a completely different purpose than the carbon trading market. In the REC market, renewable energy itself is the goal. In the carbon market, the only goal is to reduce GHG emissions. While many renewable energy sources, such as wind and solar, will also reduce GHG emissions, that is not the case for all renewable energy sources. For example, wood is a renewable energy source, but using it to generate electricity will also result in GHG emissions. The problem is that projects generating renewable electricity can sell the associated RECs to voluntary or compliance buyers. Frequently, they also have the option of selling their RECs as carbon offsets on the voluntary market. Whether or not RECs would be acceptable as carbon offsets is a complex issue, with a challenging regulatory component.

EUAs, CERs, CFIs, RGGI, can be quite confusing, but as the U.S. inevitably moves toward a cap-and-trade world under the new administration, a good understanding of the underlying tradable commodities will be essential. Think of the myriad of questions that an emitting party will likely need to answer. What are my allocated baseline emissions (are they truly baseline, or were there extenuating circumstances)? Where do I need to be (now and in the future)? How will I get there (internal emission reductions and/or purchasing allowances/offsets)? Do I have allowances to bank or sell, and if so, when and where should I? Does it make sense to trade allowances or purchase offsets created by GHG emission reduction projects? Are the offset projects legitimate? If I decide to purchase allowances/offsets, where should I go to purchase them? Should I think about hedging through the purchase of futures and/or options contracts? If so, when should I do it and for how far into the future? And these are just some of the more interesting questions! There is no doubt in my mind that an entire consulting industry will form to assist companies in getting answers to these complex questions. What an opportunity for consultants!

Carbon trading is not as simple as it may seem. As a wise person once said, the devil is always in the details!


peter said...

Accronym heaven. I guess we will eventually all have to learn this new language but my guess is we are YEARS away from this being important, given the economic mess we are in. Can even the GREEN NUTS assume the new administration is going to take steps that could, under CAP and TRADE, lead to a less robust recovery???

Tony said...

Yes and No! I would suspect that when the new administration does finally address cap-and-trade nationally as it very likely will in the next few years, carbon pricing will increase considerably. Check out carbon pricing on the European exchanges. Also, don't forget that cap-and-trade is already underway regionally in the U.S., e.g., RGGI.

Perhaps one strategy might be to acquire and hold offsets or CER futures today at their relatively low price. Of course, they must be verifiable and meet stringent standards, but if you need them in the future, this could be a way to save considerable money. For any carbon emitter, it's all part of developing their carbon strategy.